Why smart prepayment analysis means higher dividends

Refinancing activity affects prepayment speeds, which are a critical driver of mortgage REIT returns. Prepayment speeds occur because homeowners are allowed to pay off their mortgage early, without penalty, and when interest rates fall, those who can refinance at a lower rate do. This is good for homeowners. However, it isn’t necessarily good for mortgage lenders—especially REITs. When homeowners prepay, the investor loses a high-yielding asset and is forced to reinvest the proceeds in a lower-rate investment. This means lower returns going forward.

Mortgage REIT investors will therefore model prepayment speeds and search for relative value opportunities between different mortgage-backed securities. Modeling prepayment speeds is an extremely difficult process—professional mortgage-backed investors are likely to have PhDs working for them and the models are highly proprietary. That said, the benefits of doing the prepayment analysis can mean several basis points of excess return in an MBS. As you can see in the above chart, Ginnie Mae MBS have experienced the biggest drop in prepayments, which means REITs would likely want to switch out of Fannie Mae mortgage-backed securities into Ginnie Mae securities. When you consider the leverage that most REITs operate under, those several basis points can translate into an extra half a percentage point of dividend yield. So it’s worthwhile for a REIT investor to pay attention to prepayments.

Highlights of the report

This report covers data through the end of September, and rates didn’t really start falling until after the September FOMC meeting, when the Fed decided to maintain MBS purchases. So it’s possible that prepayment speeds could pick up, but it’s likely that anyone who has been able to refinance has already done so. This is called “prepayment burnout,” and it means that when rates are volatile, the effects on prepayment speeds are highest early in the process. As time goes on, the effect lessens.

Through the end of September, prepayment speeds were at the lowest level since May of 2011. The Mortgage Bankers Association refinance index has been decimated since May, when rates began to rise. The drop in prepayment speeds is a positive for the REITs, but the increase in interest rates hasn’t been.

Implications for mortgage REITs

A rise in prepayment speeds could negatively affect REITs, like American Agency Capital Corp. (AGNC), Annaly Capital Management, Inc. (NLY), Hatteras Financial Corp. (HTS), CYS Investments, Inc. (CYS), and Capstead Mortgage Corporation (CMO). That said, the increase in rates has basically put prepayment worries on the back burner for the REITs. The lack of a reaction in the refinance index on the back of a drop in rates could mean we’re finally seeing prepayment burnout. This would be good news for the REITs.

However, as rates increase, prepayments become less of a problem for REITs. But increasing rates bring their own set of problems, and REITs face mark-to-market hits on their portfolio and must adjust their hedges to a more volatile interest rate environment. Mortgage-backed securities outperform in stable interest rate environments, but they’re highly vulnerable to interest rate shocks. As we’ve seen from the mortgage REIT earnings so far, virtually everyone is reporting a substantial decline in book value, as higher rates have taken their toll. It would be ironic to see the only silver lining of increased rates (lower prepayment speeds) taken away from the REITs as well.

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